I am a senior editor at Forbes, covering legal affairs, corporate finance, macroeconomics and the occasional sailing story. I was the Southwest Bureau manager for Forbes in Houston from 1999 to 2003, when I returned home to Connecticut for a Knight fellowship at Yale Law School. Before that I worked for Bloomberg Business News in Houston and the late, great Dallas Times Herald and Houston Post. While I am a Chartered Financial Analyst and have a year of law school under my belt, most of what I know about financial journalism, I learned in Texas.

Assured Guaranty Victory Over Mortgages May Mean Trouble For BofA

A federal judge in New York yesterday handed Assured Guaranty a victory that could spell trouble for Bank of America in its fight to avoid paying for losses on defaulted mortgages issued by its Countrywide unit.

Judge Jed Rakoff held that Flagstar Bank must pay Assured Guaranty $90.1 million plus attorneys fees and costs for stuffing securities that Assured guaranteed with defective mortgages. Rakoff’s ruling could have an impact on similar litigation pending in New York courts, including MBIA‘s multibillion-dollar lawsuit against Bank of America for breaching its representations and warranties on MBIA-guaranteed bonds. In a sign investors took the ruling seriously, MBIA shares rose 18% today, almost twice as much as Assured Guaranty.

Rakoff’s decision supports the argument by so-called monoline insurers that they merely have to prove a mortgage underwriter violated its contract terms in order to collect damages. BoA and others have tried to liken insurers to sophisticated investors with a duty to perform their own due diligence on the securities they guaranteed.

Rakoff rejected that idea in his 103-page decision, saying Flagstar had violated its contract with Assured by stuffing securities with mortgages issued to borrowers with clearly inflated incomes and misrepresentations on details such as whether they lived in the homes they were borrowing against. He also agreed with Assured Guaranty that the insurer doesn’t have to prove errors in specific loans caused specific losses, but merely that the shoddy underwriting practices made the policy riskier than Assured expected. Securities issuers can adjust the risk in such bonds by requiring more cash to build up inside the security before it begins paying interest and insurers can reduce their risk by increasing the losses bondholders must bear before the policy kicks in. Assured paid out about $90 million in claims on two defaulted Flagstar bonds at issue in the case.

The decision by Rakoff, a federal judge, isn’t binding on other courts but since he applied New York law and is well respected it should have an impact on other cases, said Jacob Buchdahl, a partner with Susman Godfrey who represented Assured Guaranty in the trial.

“He’s the kind of judge who tends to be highly persuasive to other courts, and he’s written here over 100 pages,” said Buchdahl, a former federal prosecutor. “So it’s the kind of thing that’s likely to be influential.”

The tricky part in proving these cases has been establishing a method for compensating insurers. Banks want to refund only those mortgages that defaulted, while insurers say the entire pool was tainted by shoddy underwriting practices that made their risk calculations flawed.

Rakoff acknowledged the case represented a “war of experts” but sided with Assured Guaranty’s expert, Rebecca Walzak, who found that 484 out of 600 randomly selected loans had material breaches. Flagstar argued that Walzak was a management consultant with no underwriting experience and only three of the 126 defaulted mortgages in the sample actually had material breaches.

But Rakoff found Walzak’s methodology sound and consistent. MBIA is using a similar sampling method in its case against BoA.

“The Court finds that, with minor exceptions, Walzak’s conclusions in these respects were fully credible and corroborated in numerous ways,” he wrote.

Buchdahl said the claims in his case were “virtually identical” to those in lawsuits MBIA is pursuing against Bank of America. In both cases, the insurers argue they wouldn’t have issued policies, or would have adjusted them to be less risky, if they’d known the true quality of the mortgages. Assured Guaranty also successfully argued for damages based on the estimated number of bad loans, rather than an order requiring the lender to take back specific mortgages that failed. Judge Rakoff agreed that by not replacing faulty loans as they failed, Flagstar undermined the structure of the security, which was designed to develop a cushion of cash to cover projected defaults.

“There have been plenty of settlements so far, but at a substantial discount,” Buchdahl said. “This order essentially gave Assured Guaranty everything we asked for.”

Bank of America has paid out some $40 billion to settle lawsuits over Countrywide securities and has reserved another $19 billion. But a pending $8.5 billion settlement of claims by institutional investors scheduled for a fairness in hearing in May may be jeopardized if MBIA wins its case, particularly a ruling holding that BoA is legally liable for Countrywide losses. The earlier settlement is based partly on the premise that Countrywide’s parent can’t legally be found liable.

Buchdahl said there was “some reluctance” on from both insurers and banks to taking this case to trial instead of settling, since an adverse ruling either way could be very damaging in other actions.

Rakoff’s decision makes for interesting reading, and supports the idea that there was plenty of fraud in the mortgage business — especially by borrowers who lied on their loan applications. That may have been encouraged by mortgage brokers hungry for a fee, but it doesn’t absolve the borrowers of breaking the law.

A couple of examples:

One borrower was supposedly a “corporate production manager” earning $20,200 per month. Yet a consultant found that, according to the Bureau of Labor Statistics, the 90th percentile income for this position at the time was $11,850 per month. It also verified with the borrower’s employer that his income was $3,981 per month and the borrower had an undisclosed mortgage on another property for $77,250.

Another borrower said he was an electrical engineer employed by the local school district making $8,850 per month, well above the 90th percentile of $4,973 for engineers in his area. The borrower also failed to disclose he was buying other properties in the area at the time, (Florida during the bubble) and lied that he would occupy the home as his primary residence.

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Dan, you made an error in the fourth paragraph. It should be: “Rakoff rejected that idea in his 103-page decision, saying [Flagstar had violated its contract with Assured] by stuffing securities with mortgages issued to borrowers with clearly inflated incomes and misrepresentations on details such as whether they lived in the homes they were borrowing against.”